Why Trade Deficits Are Key To U.S. Financial Dominance

It’s not with China or Mexico, but with Amazon. I buy all sorts of goods from them, and Jeff Bezos has yet to spend a penny with me.

And it’s fair. I’m happy with the items, and Amazon is happy to receive my money.

Using the word “deficit” in conjunction with trade sounds bad to most people. We all know that a deficit in our personal finances means we spend more than we make, which is bad.

Likewise, President Trump seems to think the country with a trade deficit automatically “loses” to the one with a surplus.

But it’s not true. I wish his advisors would educate him on this.

One thing my readers appreciate in my writings is that I make complex information simple.

Today, I will try to make the idea of a trade deficit, an already simple thing, even simpler.

Trade Deficits Are the Reason the Dollar Is a Reserve Currency

Let’s pause here and define our terms.

A trade deficit occurs when Nation X purchases more goods and services (by value) from Nation Y than Y purchases from X. In this example, X has a trade deficit with Y and Y has an identical trade surplus with X.

And that works for every other country that we run a trade deficit or surplus with. We buy their goods, they take our dollars.

And that’s not bad. In fact, it’s arguably better for the U.S. side because China (and everyone else) accepts our currency as payment.

The U.S. can do that because we have the world’s reserve currency, which is an exorbitant privilege.

Actually, trade deficits are the reason the U.S. dollar is the world’s reserve currency. We ship enormous quantities of greenbacks overseas to pay for all the stuff we import.

Our trade partners have to accept them (as opposed to some other currency) because the U.S. is such a large customer. We carry the big stick.

Better yet, all those dollars eventually come back home because they are of limited use to foreigners.

Chinese investors use them to buy our Treasury bonds or other purchases. The money flows to other countries and companies and eventually comes back to the U.S.

Their added demand lets our Treasury borrow at lower rates than it otherwise could. In effect, the trade deficit subsidizes our government debt (which is too high, but that’s another subject).

So we see trade deficits aren’t necessarily bad, but that’s not all.

Why Seeking a Trade Surplus Makes No Sense

Even if we wanted to get rid of the trade deficit, it’s not clear we could.

Even if we could, it would create some serious side effects. Martin Wolf said it well in the Financial Times last week.

Serious economists, back to Adam Smith, would insist that seeking a surplus with every trading partner is not “winning.” It is absurd. This is not even intelligent mercantilism, which would focus on the overall balance. Yet, particularly with free capital flows, overall balance is a foolish goal and one that trade policy cannot achieve. It is incredible that such primitive ideas rule the most sophisticated country on earth.

Martin’s point is well taken.

Whether a country’s balance of trade is helpful depends highly on the conditions. They aren’t automatically good or bad.

The U.S. trade deficit is helpful, as I’ve described.

But in Greece, a few years ago, it was disastrous. The internal trade deficit southern eurozone countries ran with Germany (and other highly productive European countries) let them run up massive government, personal, and corporate debt, which they couldn’t pay.

In a normal world, when Greece used the drachma, the currency valuation would have fallen and made Greek citizens demand fewer imports. What actually happened was all the debt became due, forcing massive austerity in a kind of shadow devaluation. It was simply brutal.

Germany’s corresponding trade surplus with other EU countries is not necessarily great, either. Germany is the world’s third-largest exporter.

It could not do with a strong currency like the Swiss franc. It works only because it is in the eurozone with weaker economies.

A Volkswagen or Mercedes-Benz valued in deutsche marks that cost 50% more wouldn’t compete very well on a global scale.

Germany will learn that the hard way before this is all over.

Creating a Massive Currency Crisis

There’s one thing about trade deficits that surprises me.

The same people who want to do away with the trade deficit often worry about the dollar losing its reserve status. That may happen in some distant future. But slashing the trade deficit will only expedite it.

By being the world’s reserve currency, and by making the Federal Reserve the world’s central bank, we have agreed to supply dollars to the rest of the world so that they can trade with them.

The U.S. has done a remarkable job of running trade deficits and supplying those dollars. It is what my friend Paul McCulley calls being “responsibly irresponsible.”

If we didn’t provide those dollars, the world would find another currency to trade in, and the U.S. would lose the exorbitant privilege and its benefits.

We already see the early stages of this process.

As a result of the still relatively small tariffs, the U.S. dollar has torn higher against other currencies. This is just supply and demand. The supply of dollars outside the U.S. is shrinking, making each one more valuable.

The consequences aren’t good for the U.S.

For one, a stronger dollar makes U.S. exports more expensive and encourages other countries to seek alternatives to American goods.

Worse, the stronger dollar penalizes every U.S. exporter, not just those unlucky enough to get hit by tariffs.

The other consequence is even scarier.

Foreign governments and corporations, especially those in emerging market countries, owe trillions in dollar-denominated debt. The rising dollar is making it more expensive to repay those debts.

Governments and central banks are taking heroic measures to help but can only do so much. Eventually, some will default. Then we will have an old-fashioned currency crisis in a world far more interconnected and leveraged than it was in 1998.

Exactly how that will unfold, or when, is unclear. But there is the real possibility that it can happen.